Canada financial services

Canadian dollar weighed down by trade uncertainty

September 24th 2018 | Canada | Financial markets and instruments

Event

Uncertainty over whether Canada will be part of a renewed North American Free-Trade Agreement (NAFTA) continues to weigh on the value of the Canadian dollar—compared with its US counterpart—which has depreciated by 7% since the start of the year.

Analysis

Movements in the value of the Canadian dollar generally tend to mirror changes in the price of oil. Energy, much of which is oil, was Canada's top export in 2017, accounting for about 25% of goods exports. However, as the price of West Texas Intermediate, the benchmark price for Canadian oil, rose from below US$50/barrel a year ago to over US$70/b in September 2018, the Canadian dollar moved in the opposite direction. This does not necessarily indicate a breakdown in the relationship between the two variables, but rather the growing volatility in factors otherwise considered consistent.

Developments in interest rates, the prices of other commodities, inflation, foreign investment and international trade also affect the exchange rate. Interest rates have been rising, leading to upward pressure on the dollar. The Bank of Canada (the central bank) raised its benchmark rate four times in the past year and a half. It has indicated that another rise is likely if NAFTA negotiations with the US falter.

The current problem can be traced to the tax and trade policies of the US president, Donald Trump. The tax reforms that went into effect in January 2018 removed Canada's advantage in the taxation of investment, leading to a reduction in investment flows. Although foreign direct investment is still rising, it is weaker than expected. Furthermore, the prolonged renegotiation of NAFTA has exacerbated uncertainty for investors and raised doubts about Canada's economic prospects. When Mr Trump said that there was no political necessity to have Canada in a revamped NAFTA, the value of the Canadian dollar dropped. However, this may be a temporary situation, and the headwinds would disappear if negotiations between Canada, Mexico and the US reached a successful conclusion. Canada's finance minister could close, or at least narrow, the investment tax gap in the economic statement—often a mini-budget—which he will deliver before Christmas.

Impact on the forecast

We expect a renegotiated NAFTA including all three parties to be concluded before end‑2018, and the end-period exchange rate for the year to be at C$1.3:US$1.